Oil markets risk rapid repricing – Part 1

Since 1900, as the chart shows, oil prices have never been so high for so long as now. Until 2003, they had only been above $30/bbl for 4 years between 1979-1982, during the OPEC production cuts in the Iran crisis. But since 2004, they have been continuously above this level.

The reason is the misguided stimulus policies of western central banks, which aimed:

• Firstly to support US/European housing markets until the sub-prime lending crisis of 2008
• Secondly to enable a speedy return to full economic recovery since then

The 2004-8 period boosted consumer demand well beyond sustainable levels, causing inflation to rise quite dramatically. Thus when the second stimulus programme began in March 2009, investors were well prepared. They rushed to buy ‘stores of value‘ – commodities such as oil, copper and gold, all priced in US$ – as well as equities. They also worried that the US Federal Reserve aimed to devalue the US$ to boost US exports and economic gtrowth.

Unfortunately for all of us, this pushed oil prices back up to unsustainable levels again. But this time, due to the financial crisis, there was no demand surge. Instead, as credit was no longer easily available, people had to cut back spending. They had to heat their homes and fuel their cars, so they had less to spend on the areas that would drive demand growth.

The result has been two-fold:

• Supply has leapt. 10 years is long enough for most oil companies to ‘forget’ previous history, and to invest in new output on the basis that $100/bbl prices are now ‘normal’
• Thus US oil production has reached 7mbd, a 20-year high, and is still increasing. Other sources are also booming, whilst shale gas is gaining major market share
• Demand growth has been weak. Prices in US$ were at record annual levels in 2011-12. In other major regions such as Europe and China they have been at all-time record levels
• Inventories are at record levels in many parts of the world. In the US, for example, they reached an 82-year high last week

Normally high inventories, increasing supply and low demand growth would not lead to record high price levels. But these have not been ‘normal’ times. Tomorrow, the blog will discuss the risk that oil prices might now fall rapidly back to historical levels below $30/bbl.